Stocks rallied strongly on Friday to close out the first week of gains since the start of the month. Positive sentiment is fading according to the latest University of Michigan Sentiment survey.
Feeling good about feeling bad. Now here is a theme that we haven’t experienced in almost 4 years. I know it has gone by fast, but you must go back to a time from before most of us had ever heard of coronavirus to remember this type of scenario. It was 2018 and I was traveling between all our locations holding client meetings and speaking at seminars. The central discussion was around waning corporate profits and anemic economic growth. The probability for a recession was on rise after the longest expansion in modern history. The Fed was raising its key lending rate and stocks were volatile. Ten-year Treasury Note yields were…just around where they are today, bouncing about the 3% level. Two-year Treasury Note yields topped off slightly lower than they are now, just below 3%. The yield curve was flattening, indicating that a recession might be around the corner. In December of 2017, The Tax Cuts and Jobs Act was passed which gave consumers a welcomed tax break and corporations received a windfall tax break along with an opportunity to repatriate stranded cash from non-US sales. Oh, I’m sorry, did I forget to mention that the Fed Funds rate at the start of 2018 was almost precisely where it is today? Yep, it’s true. There was a sense that things were going OK, but that the situation could change fast. As a result, stock volatility was elevated from the prior year and a half and was approaching levels not seen since 2015. As indicated by the climbing 2-year note yield, investors were anticipating that the Fed would continue to raise interest rates. The principal fear of many investment strategists was that the Fed would raise rates to quickly cause a recession, a fear that was accentuated by the delicate state of the economy. Come on, you remember now.
In the summer of 2018, the trade war with China began when the US began a series of tariff hikes on Chinese goods, which further added to fears of recession. By the time those tariffs hit, Fed Funds was just below 2%, +50 basis points higher than where we are today. GDP growth slowed in the 2nd half of the year, raising eyebrows…and anxiety of investors. Corporate earnings throughout 2018 had been buffeted by the 2017 tax package, but by the 4th quarter, those benefits were beginning to wane. Two more +25 basis point rate hikes and weak earnings pushed investors into a selling frenzy that resulted in the worst December for stocks since The Great Depression. But all of that changed when the Fed then-Chairman / now-Chairman hinted that the Fed may slow down its aggressive tightening. That changed the game for stocks which began to climb in the 1st quarter of 2019, and bonds which also began to climb, all in anticipation that the Fed would stop hiking interest rates and possibly even cut them. That was the name of the game in 2019. Bad economic data was good news, because the markets love interest rate cuts whose probabilities increased with each negative number. The bad economic data trend did continue and ultimately the Fed began to cut rates in the summer. The end result was a volatile, but profitable year for stocks, with the S&P gaining +28.9% for the year.
Then came the pandemic, which we will skip over, for discussion purposes only. Here we are in 2022. The Fed is hiking rates and threatening that there is plenty more to come. The economy is beginning to slow noticeably, and corporate profits are starting to plateau and even decline. The 2-year/10-year yield curve had been flattening all year and inverted briefly in April, which is a strong indicator that a recession may be looming in the future. Stocks have had a hard time coming to grips with the prospect of higher interest rates. Instead of a trade war with China, markets are contending with a real war in Ukraine. This is where things are markedly different than 2018. Inflation in 2018 was right around the Fed’s +2% target rate, where it is currently at +8.6%! Crude oil was expensive in 2018 relative to the prior several years, trading between $60 and $70 a barrel. Currently, I am sure I don’t have to remind you, crude is above $100 barrel. Last week came a very subtle hint…very subtle. The Fed Chair indicated that if economic conditions worsened, the Fed might lighten up on the brakes. That hint marked a turning point in the minds of investors, which began to factor in the possibility that the Fed would slow its hiking trajectory this year and wrap up early next year. That ultimately led to last week’s positive return for stocks. Now, bad economic news is beginning to be perceived as good news for stocks, just like back in 2019. We were able to avert that feared recession in 2018, but it is not clear if we will get so lucky this time around. Last Friday, we got a final read of the University of Michigan Sentiment indicator, which was revised down to 50.0, lower than economists were expecting. In 2019 that same indicator topped out at 100.0! I will leave that math to you, but the addition of record-low consumer sentiment should make investors more acutely aware of just how difficult it will be for the Fed to pull off that elusive soft landing.
FRIDAY’S MARKETS
Stocks soared on Friday as investors began factoring a possibly less aggressive Fed. The S&P500 gained +3.06%, the Dow Jones Industrial Average climbed by +2.68%, the Nasdaq Composite Index rose by +3.34%, and the Russell 2000 Index ascended by +3.16%. Bonds declined and 10-year Treasury Note yields added +5 basis points to 3.13%. Cryptos advanced by +5.52% and Bitcoin traded higher by +1.87%.
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